California's cap-and-trade program has cut pollution. So why do critics keep calling it a failure?

Smog descends on downtown Los Angeles during a November afternoon in 2015. (Los Angeles Times)

After cruising along for more than two years, California's vaunted cap-and-trade program to cut carbon emissions has run into a few recent snags.

A state appeals court has signaled that it has doubts about how officials are spending billions in revenue from the program — or even if they have the right to collect the money at all. Disagreements have erupted in Sacramento over whether environmental regulators can unilaterally extend the program past 2020 or need to get the legislature's permission to do so.

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More questions arose at the state's most recent auction of emission permits in May. The permits are the linchpin of the system, which requires businesses to cap their greenhouse gas emissions or buy sufficient permits to cover any excess. For the first time since February 2013, when the quarterly auctions began, bidders stayed away in droves. Only 11% of the available permits were sold. That punched a hole in the state budget, for state finance officials expected that more than $500 million would be raised from the May sales. Instead only about $10 million came in.

We’ve reduced greenhouse gases so much that businesses don’t need all the available allowances.

Economist Frank Wolak of Stanford, explaining the low demand for carbon allowances at the state's most recent cap-and-trade auction

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Even environmentalists who support the program have acknowledged that the program faces "headwinds" and "uncertainty." The auction results have prompted critics to go further, forecasting the demise of cap-and-trade.

For some, the collapse couldn't come soon enough. The California Chamber of Commerce, which brought the lawsuit under review by the appeals court, says the mandate that industries buy emissions permits amounts to an illegally levied tax that imposes "massive financial burdens on a small segment of California's business community."

Others point to evidence that the program has driven up gasoline prices by as much as 11 cents per gallon (though that's a fraction of the increase the oil industry originally predicted). Legislators are irked that the program may not produce all the revenue that was promised and squabble over how to distribute the money that does come in.

But the program's supporters, including the state Air Resources Board, which runs the program, say cap-and-trade is doing exactly what it's supposed to do, achieving its goals without holding back economic growth. They're right.

The state is on course to meet its goal to reduce overall greenhouse gas emissions in 2020 to their 1990 levels. Regulators are confident that the utilities, refineries and other industries covered by the cap-and-trade program will meet the goal of reducing their own emissions to 334.2 million metric tons by 2020, a reduction of more than 15% from 2015.

As part of a sheaf of state anti-pollution programs, cap-and-trade isn't responsible for all that reduction. But it probably plays a significant role. Indeed, the board reported in November that 2014 emissions from covered industries came in 9% below the mandated limit for that year, prompting Air Resources Board Chairwoman Mary Nichols to declare the program "officially a success."

The state's May 2016 carbon permit auction was its worst ever in term of demand.

The public appears to be on board. A recent poll by the Public Policy Institute of California found that 69% favor the state's mandated pollution reduction goals and that more than 50% favor cap-and-trade. And Gov. Jerry Brown says he's determined to protect the program from attacks by the oil industry and other polluters.

So what's the problem? To understand that, it's important first to understand how cap-and-trade works.

Regulators basically have two primary ways to reduce pollution. They can order industrial emitters to take a specific step such as installing clean-air equipment — a system known as "command and control" — or they can offer incentives to get industries to act voluntarily.

Under cap-and-trade, the Air Resources Board established a statewide limit on emissions from the industries covered by the law, which are the source of about 85% of the state's output of carbon dioxide and other greenhouse gases. Companies were assigned individual targets based on their emissions history.

Companies can choose to meet their targets by cutting back operations, installing anti-pollution equipment, or buying emission permits, or "allowances," via the cap-and-trade system.

The law requires the proceeds from the allowance auctions, which were projected to be $2.4 billion in 2015-16, to be used on programs devoted to battling climate change. A large share of the funds, for example, is designated for construction of the high-speed rail system.

Each year, the allowances are reduced and their price is increased — a key tool for reducing statewide emissions. This year, the statewide cap is about 382 million metric tons of carbon dioxide or its equivalent, and the minimum price of a permit is $12.73 per ton.

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A company that figures its cost for pollution control equipment would be less than $12.73 per reduced ton presumably would install the equipment; if the cost would be higher than that, it would buy the needed allowances instead. The goal is to hold businesses to their emissions targets while giving them flexibility in how to do so.

One other factor: Businesses can buy allowances either at the quarterly auctions or in a secondary market, where traders hope to turn a profit by reselling them at a higher price than they paid.

Starting with the first auction in November 2012, there were almost always more bids than available allowances, so the state collected its expected revenue and prices remained stable.

In a surprise ruling Feb. 9, however, the U.S. Supreme Court suspended the Obama administration's "clean power plan" mandating cuts in emissions from fossil-fueled electric plants until further judicial review. The case didn't specifically deal with California, but the decision rattled energy traders who buy and sell California carbon permits.

Then, on April 8, a California appeals court unexpectedly asked for additional briefs in the California Chamber of Commerce's 2012 lawsuit challenging the state's right to raise money via cap-and-trade. The request hinted that the court might be looking more favorably on the chamber's position than observers thought.

Throw in uncertainty about the program's fate after 2020, and traders felt the urge to bail. "Folks in a buy-and-hold mode liquidated their holdings rather than risk exposure to a program that might be terminated," says Michael Gibbs, a top state air board official.

Suddenly there were abundant allowances for sale in the open market. Prices fell below the minimum auction price. So industries bought up the allowances they needed in the open market and skipped the May auction.

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But that's the way the trading part of cap-and-trade is supposed to work. Those who argue that the program is failing merely because allowance sales aren't generating the income the state expected have their eyes on the wrong ball. "Cap-and-trade needs to be judged first and foremost on how it reduces emissions," says Erica Morehouse, who monitors the program for the Environmental Defense Fund. "Raising revenue is not a measure of its success."

It's anyone's guess how long the oversupply of permits could last, dampening auction results. But there's little reason to expect it to continue indefinitely. The Air Resources Board can hold unsold allowances off the market for at least nine months, squeezing the supply and forcing participants back to the auction.

Some experts take the May auction result as a sign that the cap-and-trade program is working better than expected, or at least that California industry is more adept at cutting pollution than anyone expected when the system was enacted in 2006. "The reality is, this is a very innovative economy," says Frank Wolak, an energy economist at Stanford. "We've reduced greenhouse gases so much that businesses don't need all the available allowances."

The key to the program's continued success, Wolak adds, is its extension beyond 2020, along with more stringent requirements for emissions reductions. Since greenhouse gas reductions affect the climate over long periods, it's crucial to give industry the assurance that the investments they make today in anti-pollution technology will continue to yield benefits for the long term.

Cap-and-trade is the best way to communicate that, he says. "It would be a tremendous shame to not extend the program to 2030," he says, "unless you don't think we should address climate change."